David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Colgate-Palmolive Company (NYSE:CL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Colgate-Palmolive Carry?
The image below, which you can click on for greater detail, shows that at June 2023 Colgate-Palmolive had debt of US$8.99b, up from US$7.99b in one year. On the flip side, it has US$1.09b in cash leading to net debt of about US$7.90b.
A Look At Colgate-Palmolive’s Liabilities
We can see from the most recent balance sheet that Colgate-Palmolive had liabilities of US$4.63b falling due within a year, and liabilities of US$11.3b due beyond that. On the other hand, it had cash of US$1.09b and US$1.66b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$13.2b.
While this might seem like a lot, it is not so bad since Colgate-Palmolive has a huge market capitalization of US$60.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Colgate-Palmolive’s net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 16.5 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Colgate-Palmolive saw its EBIT slide 6.4% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Colgate-Palmolive can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Colgate-Palmolive produced sturdy free cash flow equating to 68% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
The good news is that Colgate-Palmolive’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Colgate-Palmolive can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet.